In the epilogue of my investing saga, I mentioned that stock values invariably result from three sets of circumstances. Either the publicly-traded business is: Unloved (temporarily out of favor), Undiscovered, or not Understood by the investment community. I refer to these circumstances as the UUU of value investing. Frequently these rubrics will overlap, resulting in a combination of several of the categories.

Typically the market is reasonably efficient in producing a price which is commensurate with the underlying value of an equity. However, on certain occasions an investor can purchase a stock at a substantial discount to its intrinsic value if the market misdiagnoses the future earnings of a company or fails to appreciate the understated value of a company’s unique set of assets. During this window of opportunity, an astute investor can purchase securities which will virtually assure him/her of future profits so long as the buyer has correctly assessed the value scenario and possesses the patience to wait for the stock to rise to a level near its fair value.

All experienced value investors are privy to the knowledge that not “all that glitters is gold” in regard to seemingly under- priced equities. Many times the market is perfectly justified in assigning a “bargain” price to a stock. In such cases it is the investor rather than the market that is mistaken in regard to the underlying value of the equity. Stocks which appear to be discounted but hold little in the way of underlying value are commonly referred to as “value traps”.

Value traps are generally a function of a dying business model, a temporary upswing in the earnings a low-quality business, or the result of a previously dominant business which has fallen prey to a technological innovation or a culturally-based change in consumer demand.

Very few businesses possess enduring moats which insure that their profits will remain intact over long periods of time. Consumer preferences are subject to change and entrepreneurs are continually developing disruptive business models which threaten the future profits of market-leading businesses. It is incumbent upon the investor to ascertain whether a low valuation is truly warranted or merely a function of one the UUU classifications. In the case of unloved or misunderstood businesses, the underlying question the investor must ask is whether the business is in secular decline or is merely suffering from a temporary earnings shortfall. If the business is in secular decline, then the investor is generally better served to look elsewhere for a bargain.

The remainder of today’s discussion will focus upon the selection of undiscovered stocks. Contrary to the popular idiom, if it appears "too good to be true it probably is" that frequently is not the case when analyzing tiny, undiscovered companies.

Without question, the easiest road to success in value investing involves uncovering tiny businesses which are deeply discounted. The reason for this proclamation is quite simple: the value investor encounters much less competition when purchasing such entities. Large value funds disdain tiny companies since they are generally unable to purchase significant stakes without driving up prices while many individual investors are leery about accumulating stock in small companies because of their inability to liquidate their positions due to the small floats and low volumes of the of the companies. Further, typical investors shy away from small obscure companies, believing that such entities are inherently riskier than their larger brethren. In many cases it is exactly that fear which generates opportunity for value shoppers.

Of course, not all micro-cap stocks are as cheap as they appear and the investor must spend a sufficient amount of time researching and analyzing the business. Additionally, an investor is generally better served if he/she is certain that the management and the board are totally committed to shareholder value. Unfortunately, a significant percentage of small publicly-traded companies merely pay “lip service” to best interests of their shareholders.

Frequently, executives of tiny company’s are drastically overcompensated and other times the business provides its founder and his relatives with a lifetime paychecks without regard to the net worth of their contribution to the business. Nothing is more maddening for the investor than to purchase shares in a highly profitable company where the executives and board members reap all the rewards while the shareholder is accorded little in return.

Other times, small companies engage in serial stock buybacks for the express purpose of reabsorbing excessive shares which were granted to the management and board as compensation. The price of the repurchased shares becomes irrelevant to management; rather the management is intent upon maintaining a stable share count. In essence, the profits of the business are returned to the management (through stock options) instead of its shareholders without any evidence of shareholder dilution.

At times an investor will uncover a seemingly under-priced equity and purchases shares, only to find out later the reason for its perpetual discount. Such errors can be avoided if the micro-cap investor follows certain steps which can reveal whether the management and its board are “shareholder friendly”.

The following discussion of Continental Industries (CUO), should providers with some insight of what they should look for in tiny companies. My no means could CUO be construed as a high quality business (in reality the holding company contains three good business and one poor one). Although the business provides an excellent template for what an investor should look for in terms of a management and board of directors whose interests are aligned with the minority shareholders. Additionally the 10K provides a valuation which reveals the management’s estimate of the fair value of the entire entity.

For the record, I made numerous small purchases of CUO in 2013 at an average price of 15.16 dollars per share with commission included. I intend to add to my position if I am able to purchase additional shares at a price that reflects a discount to book value of at least 50 percent.

The Intrinsic Value of CUO

Continental Materials is one of the few publicly-traded companies which publishes an estimate of the intrinsic value of their businesses in their annual report. The following information is taken from their 2013 10K filing:

Market Capitalization

Market Capitalization

Based on

Based on the highest

December 28, 2013

2014 year-to-date

Closing Price

Closing Price of

$19.75 Per Share

$21.38 Per Share

Estimated Fair Value of Reporting Units

$

67,000

$

67,000

Less outstanding funded debt as of 12/28/2013 and 2/12/2014

(4,408

)

(3,283

)

Net Fair Value of Reporting Units

$

62,592

$

63,717

Market capitalization:

1,638,000 and 1,650,000 common shares outstanding, respectively

$

32,351

$

35,277

Adjustment for corporate expenses after income tax effect

13,672

13,672

Adjusted Market Capitalization

46,023

48,949

Control Premium

16,569

14,768

Fair Value of Reporting Units as determined above

$

62,592

$

63,717

Control Premium as a percentage of Adjusted Market Capitalization

36

%

30

%

This intrinsic value estimate for the four business segments is based up a discounted cash valuation using a 13% discount rate for the three profitable segments and the estimate of an investment bank for the unprofitable Concrete, Aggregates, and Construction Supplies segment (CACS).

Without going into a detailed analysis of the tiny holding company, the business consists of three profitable segments and one losing segment; specifically the CACS business. In 2013 the ROA of the three profitable segments was 17% as opposed to a negative ROA for the CACS segment of 14.3%. Since the housing downturn, the low margin CACS business has crippled the earnings of the overall business which has resulted in a depressed stock price. In the opinion of the author, if the CACS segment was sold or should it turn profitable in the near future, the valuation of the stock would quickly rise to a level more indicative of its fair value.

The Ownership Structure of CUO

Continental Materials is a controlled company which is 62% owned by the Gidwitz family. The board is also well represented by the family and they all draw modest compensation which is largely paid out in reasonably priced stock options which aligns their interests with the rest of the shareholders. From the 2014 proxy statement:

Director Summary Compensation Table

The table below summarizes the compensation paid by the Company to non-employee directors for the fiscal year ended December 28, 2013. The Company does not currently compensate the Board members except as discussed above.

Name (1)

Total Fees Earned

or Paid

in Cash (2)

Total Fees Earned

or Paid

in Stock (3)

Total

William D. Andrews

$

3,000

$

25,500

$

28,500

Thomas H. Carmody

9,750

25,500

32,250

Betsy R. Gidwitz

3,000

25,500

28,500

Ralph W. Gidwitz

3,000

25,500

28,500

Ronald J. Gidwitz

3,000

25,500

28,500

Theodore R. Tetzlaff

8,250

25,500

33,750

Peter E. Thieriot

12,750

25,500

38,250

Darrell M. Trent

8,250

25,500

33,750

(1) James G. Gidwitz, Chief Executive Officer and Chairman of the Board, is not included in this table as he is an employee of the Company and receives no additional compensation for his service as director. Mr. Gidwitz’ compensation is shown in the above Executive Summary Compensation Table.

(2) None of the directors received perquisites or other personal benefits.

James G. Gidwitz is the CEO and Chairman of the company and his average overall compensation for the past years is approximately 623 thousand dollars. In 2012 and 2013 his base salary has been dropped to 442 thousand dollars. Along with three other relatives, Mr. Gidwitz holds a controlling interest in the stock which are mainly held in family partnerships and trusts. It could be argued that Mr Gidwitz is somewhat overcompensated (in terms of his base salary and bonuses); however the overall interests of the non-controlling shareholders are basically aligned with the board.

Summary

Value stocks are generally a function of three sets of circumstances:

-The stock is undiscovered

-The stock is misunderstood

-The stock is currently out of favor

An investor must be careful not to confuse a “value trap” with one of the aforementioned sets of circumstances.

A value trap generally results from:

-A temporary upswing in earnings in a “low quality business”

-A dying business model

-A formerly dominate business which has fallen prey to a technological change or a culturally-based change in consumer demand

The easiest way for an individual investor to outperform the indices is to identify small undiscovered companies which are overlooked by large institutional investors.

When purchasing stock in small companies, an investor must be reasonably certain that minority shareholders interests are aligned with those of the board and management.

In some small publicly-traded companies, management and board members reap all the profits of the business hence the share price of the stock becomes terminally depressed.

Disclosure: Long CUO

About the author:

John Emerson

I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

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